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Capital Structure and Profitability: S&P 500 Enterprises in the Light of the 2008 Financial Crisis

©2009 Masterarbeit 137 Seiten

Zusammenfassung

Inhaltsangabe:Introduction:
General Definition and Justification of Issues and Objectives:
The publication of the Modigliani and Miller (MM) capital structure irrelevance theorem in 1958 and the subsequent preference of purely debt financing due to tax advantages in 1963, was in contradiction to traditional approaches which suggested an optimal capital structure. Meanwhile the theories of MM are academically accepted and out of competition with other approaches, since the underlying assumptions, especially the existence of perfect capital markets, is considered as unreal. However, in every economic boom, when access to capital becomes easier, financial markets seem to come close to the conditions of perfect markets, characterised by high competition and prosperity.
It is found that the western economic order is marked by asset bubbles that resulted in over one hundred crises over the last three decades and which bring companies back to reality with a hard landing. Access to capital becomes extremely restricted and uncertainty dominates as the collapse of Lehman Brothers in September 2008 showed. Although signs were evident in 2007, the change from prosperity to depression can come overnight, where free market policy shows its true face, with unpredictable damages deeply wounding in the economy, and seeming to paralyse even the most experienced economists.
Since liquidity becomes a scarce resource and consumption declines, free cash flows that were previously available to finance an amply corporate structure, dividends and bonuses, are likely to fall. As debt, if any, must still be paid back – often to worse conditions than before – corporations might run out of liquidity, as has happened to major US companies during the last twelve months. Also, investments that ought to ensure future profits are likely to be reduced or to come to a still stand, sending firms and the economy in a downward spiral. However, as experienced and predicted by Copeland and Greenspan, systematic organisations which are considered as ‘too-big-to-fail’ are offered bail-outs at the cost of society.
This work aims to investigate the impact of the capital structure on the profitability of large capitalised US companies. It does not, therefore, aim to test existing theories, nor does it try to find a model to predict one or another capital structure, since numerous attempts have previously been made that have so far struggled to capture the full complexity of the real world. […]

Leseprobe

Inhaltsverzeichnis


Elmar Puntaier
Capital Structure and Profitability: S&P 500 Enterprises in the Light of the 2008
Financial Crisis
ISBN: 978-3-8366-4391-7
Herstellung: Diplomica® Verlag GmbH, Hamburg, 2010
Zugl. University of Leicester, Leicester, Großbritannien, MA-Thesis / Master, 2009
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2
Contents List
Abbreviations...4
Acknowledgements ...5
Abstract ...6
1 Introduction ...7
1.1 General
Definition
and Justification of Issues and Objectives...7
1.2 Research
Questions and Methodology ...9
1.3
Overview and Organisation of Chapters ...10
2
Existing Theories and their Predictions ...13
2.1 Existing
Theories ...13
2.1.1 The
Trade-Off Theory ...16
2.1.2 The
Pecking
Order Theory...19
2.2
Predictions of Existing Theories...22
2.2.1 Capital
Structure and Industry ...22
2.2.2 Capital
Structure and Profitability...26
2.2.3 Capital
Structure and Liquidity ...28
2.2.4 Capital
Structure,
R&D and Tangible Assets ...29
2.2.5 Capital
Structure and Dividend Policy...31
2.3 A
Final
Comment ...33
3 Methodology...35
3.1 Data
Sampling ...35
3.2 Data
Collection...36
3.2.1 Missing
Values
and Adjustments ...37
3.3
Variables and their Definitions ...38
3.3.1 Leverage
and Gearing ...38
3.3.2 Profits
and Return ...40
3.4
Hypotheses and Hypotheses Testing ...40
3.4.1 H
1
: Capital Structure and Industry...41

3
3.4.2 H
2
: Capital Structure and Profitability...42
3.4.3 H
3
, H
4
and H
5
: Capital Structure, Liquidity, R&D and Dividend Policy...43
4 Findings
and
Analysis...45
4.1 H
1
: The Impact of Industry on Capital Structure and Associated Variables ...45
4.2 H
2
: The Existence of a Correlation Between Leverage and ROCE...55
4.3 H
3
: The Existence of a Correlation Between Leverage and Liquidity ...60
4.4 H
4
: The Existence of a Correlation Between Leverage and R&D...63
4.5 H
5
: The Existence of a Correlation Between Leverage and Dividends ...67
5 Conclusions ...72
5.1 Capital
Structure ...72
5.2 Profitability ...73
5.3 Liquidity...74
5.4 Investments ...74
5.5 Dividends ...75
6 Recommendations...77
7 Reflections ...81
7.1 Objectives ...81
7.2 Strengths ...82
7.3 Weaknesses
and
Limitations ...82
7.4 Personal
Development...84
Bibliography...85
Appendix A ­ S&P 500 industries, January 2004 and June 2009...92
Appendix B ­ Missing values of dead firms, based on balance-sheet records ...93
Appendix C ­ Significant year-by-year correlations of core factors with Gearing 2 ...95
Appendix D ­ Independent t-test of delisted and non-delisted firms...96
Appendix E ­ Independent t-test of the ten lowest and highest geared firms ...97
Appendix F ­ Independent t-test of the ten less and most profitable firms ...114
Appendix G ­ Mann-Whitney test of the ten lowest and highest geared firms...126

4
Abbreviations
AV
Average (e.g. profits from 2004 to 2008)
bn billion
CCEG
Cash and Cash Equivalents Generic
CD Consumer
Discretionary (Sector/Industry)
CE Capital
Employed
CEO
Chief Executive Officer
CI Confidence
Interval
CS
Consumer Staples (Sector/Industry)
DP Dividends
Payments
EBIT
Earnings before Interest and Tax
EN Energy
(Sector/Industry)
FI Financials
(Sector/Industry)
H Hypothesis
HC
Health Care (Sector/Industry)
IN Industrials
(Sector/Industry)
IT Information
Technology (Sector/Industry)
MA Materials
(Sector/Industry)
MM Modigliani
and
Miller
N
Number of Cases (Sample Size)
NA Not
Applicable
NIATC
Net Income Available to Common
NPV
Net Present Value
PAT Profit
After
Tax
PBT
Profit Before Tax
PCC
Pearson Correlation Coefficient
R&D
Research and Development
ROCE
Return on Capital Employed
S&P
Standard and Poor's
Std. Dev.
Standard Deviation
SG&A
Selling, General and Administration Expenses
Sig. Significance
(Level)
SPSS
Statistical Package for Social Sciences
TE Telecommunication
(Sector/Industry)
USD US
Dollar
UT Utilities
(Sector/Industry)
WACC
Weighted Average Cost of Capital

5
Acknowledgements
History has shown that outstanding literature is seldom produced by a single mind alone
but rather from successful co-operations and valuable contributions of high-performers.
It is not incumbent upon me to judge whether this work is of high quality or not,
however, it is no exception in the way it was generated as it is the result of continuous
reflections, inspired by members of the School of Management at the University of
Leicester.
A generous acknowledgement belongs to my supervisor Dr. Geoff Lightfoot, who
delivered new ideas of how to approach issues and guided me throughout this master
thesis. Of equal importance were the recommendations and experiences of the MBA
programme leader and outstanding speaker Prof. Steve Brown in the early stage that
set the basis of successfully completing a masters degree and a research project.
Finally, it was my personal tutor, Prof. Simon Lilley, who worked inconspicuously, but
whose activities did not go unrecognized, since they provided an accurate environment
and climate.
I am also grateful to all my fellow students, who motivated and encouraged me during
the course, and all those who supported me in mastering personal and academic
challenges.

6
Abstract
The present study aims to investigate to what extent capital structure has an impact on
profitability and closely associated factors due to a series of bankruptcies and bail-outs
within the last twelve months. The analysis refers to firms listed in the S&P 500 index on
January 2004 and evaluates their performance from 2004 to 2008. The results show
strong industry-specific characteristics for all factors observed, i.e. gearing, profitability,
liquidity, investments and dividends. In addition, findings indicate a negative effect of
higher gearing for almost all ten sectors in respect of the core variables analysed.
Neither the trade-off nor the pecking order theory can be confirmed, however, more
support for the former is found. Due to the complexity of capital structure choice,
regulations have very limited effects that require the need for independent non-
governmental monitoring agencies to improve transparency and have the authority to
intervene if managers act at the expense of public interest.

7
Introduction
1.1
General Definition and Justification of Issues and Objectives
The publication of the Modigliani and Miller (MM) capital structure irrelevance theorem
in 1958 and the subsequent preference of purely debt financing due to tax advantages
in 1963, was in contradiction to traditional approaches which suggested an optimal
capital structure. Meanwhile the theories of MM are academically accepted (Fama and
Miller 1972; Kraus and Litzenberger 1973; Miller 1988; Frank and Goyal 2009) and out
of competition with other approaches, since the underlying assumptions, especially the
existence of perfect capital markets, is considered as unreal (Jackson 2009). However,
in every economic boom, when access to capital becomes easier, financial markets
seem to come close to the conditions of perfect markets, characterised by high
competition and prosperity.
It is found that the western economic order is marked by asset bubbles that resulted in
over one hundred crises over the last three decades (Stiglitz 2008) and which bring
companies back to reality with a hard landing. Access to capital becomes extremely
restricted and uncertainty dominates as the collapse of Lehman Brothers in September
2008
1
showed. Although signs were evident in 2007, the change from prosperity to
depression can come overnight, where free market policy shows its true face, with
unpredictable damages deeply wounding in the economy, and seeming to paralyse
even the most experienced economists (Atkins and Guha 2009).
1
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4761892.ece (accessed 03.04.09)

8
Since liquidity becomes a scarce resource and consumption declines, free cash flows
that were previously available to finance an amply corporate structure, dividends and
bonuses, are likely to fall. As debt, if any, must still be paid back ­ often to worse
conditions than before (Johnson 2009) ­ corporations might run out of liquidity, as has
happened to major US companies during the last twelve months (Tieman 2009; Sakoui
2009). Also, investments that ought to ensure future profits are likely to be reduced or to
come to a still stand (Giles 2009), sending firms and the economy in a downward spiral.
However, as experienced and predicted by Copeland (2005) and Greenspan (2008),
systematic organisations which are considered as "too-big-to-fail" (Hughes 2009:11) are
offered bail-outs at the cost of society.
This work aims to investigate the impact of the capital structure on the profitability of
large capitalised US companies. It does not, therefore, aim to test existing theories, nor
does it try to find a model to predict one or another capital structure, since numerous
attempts have previously been made that have so far struggled to capture the full
complexity of the real world (Arnold 2008; Ross et al. 2008; Watson and Head 2007).
Rather, it focuses on correlations between capital structure and profitability and major
profitability-associated measures that can have an impact on a firm's survival, i.e.
liquidity, dividends, investments and the impact of an industry-related target gearing
ratio as a potential systematic risk. Thus, this work is supposed to contribute to the
understanding of how resistant companies are to financial distress, and it provides
evidence on the extent to which vulnerability can be reduced to prevent major systemic
crises by means of their capital structure adjustments through the awareness of
shareholders and corporate governors.

9
1.2
Research Questions and Methodology
The basis of this research project is a selection of secondary performance data over the
period from 2004 to 2008 of firms listed in the Standard & Poor's 500 index (S&P 500)
in January 2004. The index represents the 500 largest capitalised US companies
among ten sectors that reflect the whole US market (Standard & Poor's 2008a). The
combination of the US market and the S&P 500 companies, who have access to the
widest range of financial sources, is expected to give a highly reliable result to find
empirical evidence for the following research questions.
Question 1. According to the MM theorem and the pecking order theory that relies on
information asymmetry between insiders and investors (Myers 1984), leverage should
not depend on the industry a firm is in. However, evidence (Ross et al. 2008; Antoniou
et al. 2008) suggests that firms in different industries operate with different capital
structures. Thus, the first hypothesis (H
1
) is to verify whether industry-specific leverage
exists.
Question 2. Since revenues are likely to decrease in an economic downturn, this
reduces a firm's ability to meet debt payments, which is expected to have a negative
impact on profitability. The second and central hypothesis (H
2
) is, therefore, that a
negative correlation between gearing ratio and profitability exists, i.e. higher geared
firms are less profitable. As this research question is the centre of attention, it merits a
deeper investigation than all other hypotheses, especially for the years 2007 and 2008.

10
Question 3. Most of the companies are affected by financial distress, not because they
are not unprofitable, but because they have no liquidity (McLaney and Atrill 2008). If
cash inflows decline, firms are likely to be unable to finance current expenses, including
the interests on debt. Hence, the third hypothesis (H
3
) is the existence of a correlation
between gearing ratio and liquidity. Higher geared firms are supposed to have lower
cash positions, especially in 2008.
Question 4. Investments in R&D are crucial for survival and competitiveness of firms
within some industries. Since higher geared firms must concentrate more to the
avoidance of financial distress, they may tend to reduce expenses in long-term R&D
projects that have no immediate effects. The aim of the fourth hypothesis (H
4
) is to
prove whether a correlation between gearing ratio and R&D expenditure exists,
especially in 2008, that is expected to have a negative influence on future profits.
Question 5. Highly geared companies are encouraged to pay out higher dividends by
transferring wealth from bondholders to shareholders (Ross et al. 2008), although
managers should have an incentive to reduce them if liquidity becomes a scarce
resource. The fifth hypothesis (H
5
) is, therefore, to find evidence of the existence of a
correlation between gearing ratio and dividend policy, especially in 2008.
1.3 Overview
and
Organisation of Chapters
This dissertation is organised into seven sections, each with a brief statement at the
beginning and the end of the issues previously and subsequently discussed. Although

11
this might seem repetitious, it enables the reader to go through in multiple sessions. The
following few paragraphs give an outline of the next six sections.
After the introduction and definition of the above stated research questions, section 2
attempts to review the existing literature on capital structure with a discussion of the
main theories, after which a more detailed focus on the fields in respect of the research
questions is provided.
Section 3 discusses and justifies the methodology used to answer the research
questions, which refers to data sampling and data collection, the treatment of missing
values, the variables defined and applied hypothesis testing methods.
Section 4 outlines the key findings in respect of the hypotheses initially stated, which
are then analysed and discussed. Where appropriate, the results found are related to
the most relevant findings discussed in the literature review.
Section 5 recalls the research objectives and findings previously obtained. After that, it
concludes with the underlying assumptions required for the implications drawn from
those findings, which are part of the next section.
Section 6 attempts to identify management implications and recommendations to solve
the issues. Based on the results revealed from the sample, it aims to identify measures
in reducing vulnerability and systematic risk in order to achieve sustainable economic
growth without adverse effects for society.

12
Section 7 points to the achievement of the objectives of this study, its strengths and
weaknesses. Ultimately it gives insights to the personal development drawn from the
execution of this research project with reference to difficulties faced.

13
Existing Theories and their Predictions
In the previous section the objective of this paper and its importance, as well as the
research questions are stated. This section reviews existing literature and discusses
major capital structure theories that are subsequently related to the core aspects stated
in the five research questions, where theories and findings are analysed in more detail
and lead to the expected predictions.
1.4 Existing
Theories
Following the publication of "The Cost of Capital, Corporation Finance and the Theory of
Investment" by Modigliani and Miller in 1958, scholars became busy for a while trying to
provide evidence that capital structure, i.e. the mix of equity and debt, is not irrelevant
for a firm's value. With the MM theorems, the traditional approach, according to which
"an optimal capital structure does exist for individual companies" (Watson and Head
2007:264) ­ determined by gearing level, volatility of profits, bankruptcy risk and the
weighted average cost of capital (WACC) ­ was rejected (Ross et al. 2008). To explain
that the capital structure is irrelevant, MM (1958:279) used the analogy of a dairy
farmer, who "cannot in general earn more for the milk he produces by skimming some
of the butter fat and selling it separately, even though butter fat, per unit weight, sells for
more than whole milk." Thus, it does not matter whether a company is financed by 100
percent equity or 100 percent debt, or any mix of the two, because "the increased cost

14
of borrowed funds as leverage increases will tend to be offset by a corresponding
reduction in the yield of common stock" (MM 1958:274).
Since MM assumed no taxation in their first proposition, they revised it and considered
also corporate taxation in a second proposition. MM (1963) came to the conclusion that
debt financing should be favoured, since interests can be deducted from taxes payable
that results in a decline of the WACC, if the proportion of debt increases. The optimum
is, therefore, a capital structure consisting of 100 percent debt that guarantees the
highest tax-shield. It should be noted that MM (1958; 1963) assumed perfect markets
(where firms always have access to capital to meet their debt payments, making the
capital structure independent from profit volatility), no transaction costs, no agency and
bankruptcy costs, and that individuals have access to capital markets on the same
conditions as firms.
Empirical evidence, however, has shown that firms rarely rely solely on debt financing
and that they "generally use less debt than equity" (Ross et al. 2008:419). It is clear that
taxable profit must be available to offset interests from taxes, which defines the
optimum amount of debt that a firm should take on. However, Graham (2000:1914)
finds on a sample of "87,643 [firm-year] observations from 1980 to 1994" that "[t]he
capitalized tax-reducing benefit of interest deductions is [9.7] percent of firm value"
(ibid.:1935) and could be increased by a further 15 percent, if personal taxation is not
considered.
Moreover, Graham (ibid.:1902) finds that "firms that use debt conservatively are large,
profitable, liquid, in stable industries, and face low ex ante costs of distress", who also
have "growth options and relatively few tangible assets." He identifies a trend towards a

15
more aggressive debt policy of US firms since the 1980s due to increased competition,
measures taken by tax authorities to encourage debt financing and, according to
Grinblatt and Titman (cited in Graham 2000), a reduction in transaction costs on global
capital markets. Fama and French (2004:229) give evidence that "[t]he number of new
firms listed on major U.S. stock markets jump[ed] from 156 per year for 1973­1979 to
549 per year for 1980­2001", while the probability of surveillance declined due to a
higher sensitivity to changes in supply and demand of equity. They believe that this
increase resulted from lower costs of equity issuance, while such changes were not
identified as industry-specific.
Thus, increased competition and lower transaction costs offer firms more flexibility in
their capital structure management, but firms still do not exploit the full potential of the
so-called `debt capacity' to lower the WACC and fail to optimise shareholder wealth.
This indicates that MM ignored crucial factors that influence financing decisions (Fama
and French 1998; Watson and Head 2007). As Ross et al. (2008:479) put it, "[t]he
theories of capital structure are among the most elegant and sophisticated in the field of
finance", but "the practical applications ... are less than fully satisfying"; a view shared
by Frank and Goyal (2009). This leads to different models of capital structure, other
than the propositions of MM (1958; 1963), which seem inappropriate for real world
conditions, characterised by imperfect capital markets that are never at an equilibrium
(Klein 2007; Davis 2009; Soros 2009; Triana 2009). The most popular approaches are
the `trade-off' theory and the `pecking order' model as proposed by Myers (1984), while
"[r]ecently, the idea that firms engage in `market timing' has become popular" (Frank
and Goyal 2009:1). Both the trade-off and pecking order models are discussed in the
next two sub-sections, since they are among the most cited models in existing literature.

16
1.4.1 The Trade-Off Theory
The trade-off theory dates back to Kraus and Litzenberg (1973:918), who argued that
"taxation of corporate profits and the existence of bankruptcy penalties are market
imperfections that are central to a positive theory of the effect of leverage on the firm's
market value." By completing the equation with those two factors, firms can increase
their debt level in order to maximise firm value as long as the marginal benefit of
additional debt is not offset by costs of financial distress. However, Graham (2000:1934)
points out that "many firms overestimate the effect that using additional debt would have
on the probability ... of distress" which he estimates at 33 to 75 percent is far too high, if
costs of financial distress of "10 to 20 percent of firm value" are considered, as empirical
evidence from Andrade and Kaplan (1998:1488) of thirty-one highly levered firms
suggests.
Frank and Goyal (2009:5) point to the `agency perspective', defended by Jensen and
Meckling (1976) and Jensen (1986:324), according to which "debt reduces the agency
costs of free cash flow by reducing the cash flow available for spending at the discretion
of managers." Stulz (1990) states that managers are likely to over-invest if free cash
flows are high and under-invest if they are too low, resulting in agency costs. Because
managers prefer equity and low debt levels that allow them to control the company's
resources to improve their position, Stulz (1990) argues that shareholders could force
managers to issue more debt that reduces over-investment, which thus results in an
optimum combination of debt and equity to maximise shareholder wealth.

17
However, as Reich (2009) and Bakan (2005) emphasise, the larger a company and the
more shareholders there are that own a small stake, the more they feel like investors
rather than owners, unwilling and unable to control managers, who are well aware of
this. This suggests a low debt ratio, even though a firm may be profitable with low
volatile cash inflows, as Graham (2000) finds. This is consistent with Berger, Ofek and
Yermack (1997), who find that a low CEO turnover and fewer monitoring activities result
in a suboptimal capital structure. The agency theory is also supported by Jung, Kim and
Stulz (1996), stating that firms still issue equity when alternative forms of financing are
available, and thus reducing shareholder wealth. Such a phenomenon was also
observed by Myers (1984:582), noting that "[t]here are plenty of examples of firms
issuing stock when they could issue investment-grade debt." In contrast, Graham and
Harvey (2001:226) find that under-investment problems appear more likely in "more
growth ... than non-growth firms", but the overall evidence is rather weak.
Graham and Harvey (2001) studied the capital structure behaviour of 392 chief financial
officers of small and large firms and found that tax advantages play an inferior role for
issuing debt, while personal taxation ­ in contrast to Miller (1977) ­ and transaction
costs remain almost unconsidered. Also Myers (1984) and Titman and Wessels (1988)
find no evidence that the latter is of any major importance for capital structure
adjustments. As Frank and Goyal (2009) note, although corporation tax influences
behaviour, it is difficult to anticipate and evaluate possible tax advantages, since the
existence of transaction costs makes it more difficult to find evidence. However, "tax
advantage is most important for large, regulated, and dividend-paying firms" if the
benefits achieve a certain satisfactory level (Graham and Harvey 2001:210). Large firms
are also more worried about their credit ratings than financial distress (ibid.). Therefore,
it is less surprisingly that only 19 percent of the firms have no target ratios ­ since credit

18
ratings also consider the probability of financial distress ­ while 37 percent have a
flexible and 44 percent a more or less concrete target gearing ratio (ibid.). They point
out that "[t]argets are important if the CEO has short tenure or is young, and when the
top three officers own less than 5% of the firm" (ibid.:211). Although, there is some
support for the trade-off theory, it is not fully approved.
A dynamic model that considers financial restructuring, due to macroeconomic changes,
is offered by Fischer, Heinkel and Zechner (1989), applying regression analysis on a
sample of 999 firms on a quarterly basis from 1977 to 1985. They found that "smaller,
riskier, lower-tax, lower-bankruptcy-cost firms will exhibit wider swings in their debt
ratios over time", as smaller firms are more sensitive to transaction costs ­ consistent
with Titman and Wessels (1988) ­ and finally intervene only if debt considerably
exceeds a desired level (Fischer, Heinkel and Zechner 1989:39).
Consistent with this approach is the research of Frank and Goyal (2009), carried out on
over 200,000 publicly traded US firms from 1950 to 2003. The correlations between
leverage and a series of factors (25 in total) give evidence of six `core factors' that have
the highest impact on capital structure: "1) Industry median leverage, 2) Tangibility,
3) Market-to-book assets ratio, 4) Profitability, 5) Log of assets, and 6) Expected
inflation", of which only profitability is inconsistent with predictions of the bankruptcy-tax
trade-off model (Frank and Goyal 2009:18). In consideration of all 25 factors, they
constructed a regression model with market leverage as a dependent variable that gave
evidence of a decline in the impact of those factors from 42 percent to 24 percent from
1950 to 2003 that explains debt levels (ibid.:19). Easier access to global capital markets
and lower transaction costs might have contributed to such a development.

19
Frank and Goyal (2009:4) share consistencies with Tsyplakov (2008), according to
whom "firms [tend to] stockpile retained earnings until the time is right to buy physical
capacity", while tax-shields other than debt are also considered. The latter is supported
by DeAngelo and Masulis (1980:20), who agree that "each firm has a unique interior
optimum capital structure in market equilibrium in a world characterized by ... the
equity-biased personal tax code ... [and] corporate tax shield substitutes for debt and/or
positive default costs." To conclude, Frank and Goyal (2009:27) support the trade-off
theory for "factors such as industry leverage, firm size, tangibility, and market-to-book."
However, they point out that "in dynamic trade-off models ... leverage and profits can be
negatively related", while a weakness of the trade-off is "that more profitable firms
generally have lower leverage" (ibid.:27).
1.4.2 The Pecking Order Theory
The pecking order theory was recognised as managerial practice by Donaldson (1961)
and later enhanced by Myers (1984), who implied information asymmetry between
managers and investors due to changes in stock prices, when equity issues are
announced that are considered negative news and therefore result in an asset
revaluation by stockholders (Younghwan 2007; Frank and Goyal 2009). Therefore,
Myers (1984) argues that firms should first use internal financing which also produces
the lowest transaction costs. If this is not possible, priority should be given to the safest
debt, while equity issuance ­ that also affects ownership ­ is the last means by which to
finance positive NPV projects. Because there are costs related to the adjustment of a
target debt-equity ratio, firms do not adjust their capital structure to changing
circumstances as they would without costs that leads to "no well-defined target debt-

20
equity mix", where "[e]ach firm's observed debt ratio reflects its cumulative requirements
for external finance" (Myers 1984:581).
In a replication of previous studies ­ such as Toy et al. (1974) for the US, Netherlands,
Norway, Japan and France, and Kester (1986) for the US and Japan ­ Baskin (1989)
identifies strong support for the pecking order theory on a sample of 378 Fortune 500
firms listed in 1960 over the period from 1960 to 1972. In a regression analysis, with
book value debt-equity ratio as a dependent variable, and return on assets (before
interest and tax) and growth as independent variables, Baskin (1989:33) observes that
"once [funding is] controlled, borrowing behaviour appears serially uncorrelated".
Although debt is given the priority, since information asymmetry increases "with those
securities whose value is most dependent upon publically unknown future prospects",
debt issuance is limited by bankruptcy costs that, however, seem to be "more elastic
than that of equity among [the] sample of large mature corporations" (ibid.:33). Baskin
(1989:26) sees "pecking order behaviour as the rational response not only to tax and
transaction costs, but also as a signalling equilibrium" in imperfect equity markets due to
information asymmetry that takes the form of a passive capital structure adjustment.
Support for the pecking order model is also provided by Graham and Harvey (2001) to
some extent, who find debt over equity preference for small firms only. Despite the
absence of information asymmetry, Graham and Harvey (2001:219) notice that flexibility
is consistent with the pecking order model, since especially large firms are "reluctant to
issue common stock when they perceive that it is undervalued". However, they also
state that firms who decide to remain flexible in their capital structure are likely to be
firms who pay dividends and where information asymmetry is generally low, which is in
contradiction with the pecking order theory, while "the window of opportunity [to issue

21
equity] is most important for firms suffering from informational asymmetries" that refers
to non-dividend-payers (ibid.:222). Their results indicate low association of leverage
with signalling effects that is, however, more likely for speculative organisations who do
not pay dividends and prefer equity issuance to communicate growth opportunities. The
results indicate that small firms are "more likely to suffer from informational
asymmetries" (ibid.:222), "but [there is] little evidence that executives are concerned
about asset substitution, asymmetric information, transactions costs, free cash flows, or
personal taxes" (ibid.:188).
Graham (2000) points out that neither the pecking order nor the trade-off model
explains why firms tend to be debt-adverse. While Baskin (1989) finds notable
supporting evidence for the pecking order theory that explains corporate behaviour
under consideration of asymmetric information and disregards the trade-off theory,
Frank and Goyal (2009:5) argue that "[t]he pecking order theory is often used to explain
financing decisions of firms." However, both support the view that a static optimal capital
structure, as proposed by DeAngelo and Masulis (1980), is not applicable. Frank and
Goyal (2009:5) point to Shyam-Sunder and Myers (1999) and argue that "[a] significant
merit of the pecking order theory is that it predicts the effect of profits correctly", but they
emphasise that "[it] is not helpful in organizing many of the features we see in the way
firms finance themselves" and refer to Fama and French (2002) and Frank and Goyal
(2003). Although Frank and Goyal (2009) do not aim to test the capital structure
theories, they find more supportive evidence for the trade-off model and emphasise the
importance of the industry in which a business is in, a factor that is not considered by
the pecking order theory.

22
The pecking order provides a rational explanation of management behaviour, but
evidence is not fully satisfactory. Due to the absence of an optimal debt-equity ratio, a
mature firm would be likely to have accumulated large amounts of debt that leads to a
high leverage. In a recession, a firm could then face problems of paying debt-related
interests, and if profits decrease ­ as is likely for the majority of industries (Guerrera et
al. 2009) ­ that firm would also have minor growth opportunities, especially in the short-
term. Retained earnings erode and it might become extremely difficult to raise additional
finance, due to insufficient collateral. Since share prices fall considerably, as happens
periodically in any crisis, equity issuance is hardly a reasonable option. Thus, if no
equity issue is possible, this may result in a failure, where Chapter 11 is the only valid
option. Therefore, pecking order seems to work better in stable industries with less
volatile profits.
Summarising these aspects, it seems that a firm's specific optimal debt level exists
which, due to the complexity of influencing factors that are hard to identify and to
predict, in most cases results in a flexible capital structure. This would equate to the
view of Watson and Head (2007:272), which argues that "the WACC curve will be flatter
in practice than the U-shaped curve put forward by academic theories."
1.5
Predictions of Existing Theories
1.5.1 Capital Structure and Industry
The pecking order theory suggests that leverage is industry-independent and thus in
line with MM (1958; 1963). Also DeAngelo and Masulis (1980:23) point to a firm specific

23
leverage that has no direct association with the industry. However, advocates of the
trade-off theory argue that industry does matter, as is supported by empirical evidence.
Bradley et al. (1984), Ross et al. (2008) and Frank and Goyal (2009) emphasise the
importance of industry, a factor that seems to be undervalued in most research papers.
According to Ross et al. (2008:481), "debt ratios tend to be quite low in high-growth
industries with ample future investment opportunities", while they tend to be high in
"[i]ndustries with large investments in tangible assets". He also argues that "almost any
industry has a debt-equity ratio to which companies in that industry tend to adhere"
(ibid.:439).
Industries with unique or homogeneous products ought to operate with lower debt levels
due to high risk and costs of financial distress (Titman 1984; Graham 2000; Frank and
Goyal 2009:9). This is confirmed by Titman and Wessels (1988), who find that, in a
sample of 469 firms (mostly large) from 1974 to 1982, product uniqueness results in
lower debt rates as for production and equipment manufacturers. Due to a low degree
of product diversification, those firms are forced to have higher R&D and sales
expenses (Titman and Wessels 1988) which is considered as weak collateral and
increases profit volatility. Because in the sample period of Titman and Wessels (1988)
the IT sector was less developed than it is today, low debt may also be used by firms
within the IT sector. Graham (2000:1910) comes to the conclusion that firms within
"sensitive" industries use debt moderately and, in contrast to Chevalier (1995b),
(ibid.:1930) finds that "firms in concentrated industries (high asset Herfindahl) use debt
aggressively." Chevalier (1995a) argues that in the supermarket industry an increase of
leverage results in higher competition. Thus, if low profits indicate high competition, this
would imply high debt levels for the respective industry.

24
The phenomenon of industry-specific leverage ratios may encourage firms to
benchmark themselves with their equivalent considered as `best in class' (Frank and
Goyal 2009:8). Also financial services organisations and consultancies tend to
benchmark companies to capture the complexity of an organisation's influencing forces.
This, however, can drive a whole industry in a misleading direction that may chronically
over-leverage, as is identified by Wolf (2009) for the financial sector. He (2009:15)
points out that "[i]n a highly leveraged limited liability business, shareholders will
rationally take excessive risks, since they enjoy all the upside but their downside is
capped: they cannot lose more than their equity stake". Even though sophisticated
mathematical tools are used to forecast market behaviour, they fail in the face of the
unpredictable "occurrence of the occasional extreme event", the so-called "black swan"
(Taleb and Spitznagel 2009:11). While in boom years all seems to work well,
expectations of investors and managers' targets increase (Reich 2009), an industry may
not be prepared to sustain a downturn that ultimately leads to a systematic failure as
various financial crises have shown (Khor 2001; Porter 2005; Greenspan 2008).
A second explanation provided by Frank and Goyal (2009:8) is that "industry effects
reflect a set of correlated, but otherwise omitted, factors". All companies within the same
industry have to deal with the same micro- and macroeconomic circumstances that
"could reflect product market interactions or the nature of competition", but also
"industry heterogeneity in the types of assets, business risk, technology, or regulation"
(ibid.:8). Thus, firms with unique products who operate with a more specialised
workforce are more vulnerable to macroeconomic changes that results in cash flow
volatility, which increases the probability and cost of financial distress and implies debt
conservatism, also because tax-shields remain unused if profits are omitted (ibid.).
Therefore, different industries are supposed to have a different debt level range,

25
because "higher risk should result in less debt under the trade-off theory" (ibid.:10) with
higher debt levels for more regulated industries, since their cash flows are more stable.
However, as Frank and Goyal (2009) correctly point out, under the pecking order
theory, risky businesses imply more volatile stock prices and cash flows that would
result in higher debt levels, since debt is accumulated and equity would be the last
means to raise capital required.
As Frank and Goyal (2009:8) note, "[g]rowth increases costs of financial distress,
reduces free cash flow problems, and exacerbates debt-related agency problems" that,
under trade-off, would result in lower debt levels, since those firms use significantly
more equity than firms without such growth opportunities. If growth pushes down
leverage, this implies that industries with high leverage are mature with limited potential
for growth. However, the opposite is implied under the pecking order model, because
"firms with more investments ­ holding profitability fixed ­ should accumulate more debt
over time" (Frank and Goyal 2009:8). In their study, they find that leverage and growth
are negatively correlated over the whole period from 1950 to 2003, if considered as
terms of market-to-book value in correlation to long-term debt (or total debt) to market
assets, while long-term debt to book assets results in a positive correlation. Frank and
Goyal (2009:15) also find that a high median implies higher leverage, bringing them to
the conclusion that "the most important single empirical factor is industry leverage"
(Frank and Goyal 2009:27).

26
1.5.2 Capital Structure and Profitability
While MM (1958) and Myers (1984) see capital structure as being independent from
profits, the bankruptcy-tax trade-off theory and the alternative trade-offs are very explicit
about the optimal leverage.
However, several studies (Graham 2000; Jung, Kim and Stulz 1996) indicate that
managers ­ whether intentionally or unintentionally ­ do not always contribute to
sustainable shareholder wealth. Reich (2009) points out that hyper-competition forces
CEOs to generate profits in the short-term ­ which contributes to an increase in share
prices, which in turn indicates favourable future profits ­ at the expense of long-term
profitability. While some firms will always be more profitable than others, and although
higher profits reduce the risk of financial distress and increase the effectiveness of tax-
shields through higher debt levels, "all published statistical studies conducted over 50
years in five countries show a prominent negative relationship" between profitability and
leverage (Baskin 1989:28).
Such a study conducted by Kester (1986), who compared US and Japanese
manufacturing companies, concludes that there is no significant difference in their
leverage if measured in market value, but in terms of book value, Japanese companies
are less profitable since they accumulate more debt due to a faster growth, because
"[d]uring expansion, stock prices go up, expected bankruptcy costs go down, taxable
income goes up, and cash increases" which encourages borrowing (Frank and Goyal
2009:11). A similar "relationship between debt, growth, and profits is ... found" by
Baskin (1989:28), based on a sample of "378 firms from the 1960 Fortune 500" from
1960 to 1972 and also by Antoniou et al. (2008), based on a sample of 4,854 firms from

27
major world economies (US, UK, France, Germany and Japan) from 1987 to 2000.
Baskin (1989:33) also finds that "debt leverage varies positively with past growth and
inversely with past profits." Thus, the pecking order predicts that "[i]f investments and
dividends are fixed, then more profitable firms will become less levered over time"
(Frank and Goyal 2009:7).
The use of more debt is not only promoted by the tax-bankruptcy trade-off, but also by
the agency cost model, according to which "the discipline provided by debt is more
valuable for profitable firms as these firms are likely to have severe free cash flow
problems" (Jensen cited in Frank and Goyal 2009:7). Thus, higher profitability implies
higher debt levels, but research is still ongoing, since complexity in dynamic trade-off
models seems to be vast (Strebulaev 2007). However, according to Frank and Goyal
(2009:11) "agency problems are likely to be more severe during downturns as
manager's [sic] wealth is reduced relative to that of shareholders". In their latest
research, they find that profitability and a high market-to-book ratio are significantly
negatively correlated to leverage, while industry median, tangible assets, size and
inflation are positively correlated. The negative correlation of profits to total debt-to-book
assets of -0.334, p < 0.01 was found over the whole sample period, whereas profitability
is defined as operating income before depreciation to assets (Frank and Goyal 2009).
However, Frank and Goyal (2009:19) point out that "[t]he impact of profits declines
sharply" from -0.54 in the 1950s to -0.05 at the end of the sample period, while "the
effects of firm size and dividend paying status have both increased in economic
importance."
Although Frank and Goyal (2009:26) fail to give evidence of whether firms consider
market or book value in their leverage decisions and why dividend payers operate with

28
lower debt than non-dividend payers, they find that with "book leverage, the effects of
market-to-book, firm size, and expected inflation factors all lose the reliable impact that
they have when studying market-based leverage." However, "industry median leverage,
tangibility, and profitability remain reliable and statistically significant", for which an
explanation is given by Barclay et al. (cited in Frank and Goyal 2009:26), who note that
"book-leverage is backward looking while market leverage is forward looking" and thus
market-leverage reflects future prospects that should also be related to variables that
are able to absorb information about future expectations. Nevertheless, "industry
median leverage, tangibility, and profitability appear as robust factors in various
definitions of leverage." (Frank and Goyal 2009:18)
1.5.3 Capital Structure and Liquidity
As long as an economy is growing, insufficient liquidity is only a problem if the future
prospects of a company let assume an inability to repay a loan and if satisfactory
collateral is unavailable. In a recession the laws change and access to capital becomes
more difficult, leading to an increase in the cost of capital (Johnson 2009). Since profits
decline in most industries (Guerrera et al. 2009) and share prices are generally
undervalued, it is inconvenient to issue equity that makes takeovers easy for those who
have cash. A higher geared firm must certainly pay higher interests that decrease free
cash flows, but it must also finance dividend payments and profitable investments that
might motivate it to increase borrowing more than less leveraged firms would (Baskin
1989). Although the pecking order predicts that mature firms operate with high debt
levels, those firms are expected to have less liquidity.

Details

Seiten
Erscheinungsform
Originalausgabe
Jahr
2009
ISBN (eBook)
9783836643917
DOI
10.3239/9783836643917
Dateigröße
1.7 MB
Sprache
Deutsch
Institution / Hochschule
University of Leicester – Corporate Finance, Master of Business Administration
Erscheinungsdatum
2010 (März)
Note
1,0
Schlagworte
capital structure profitability financial crisis corporate finance
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Titel: Capital Structure and Profitability: S&P 500 Enterprises in the Light of the 2008 Financial Crisis
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